For many of us, planning for retirement involves setting aside money and making strategic investments, as well as daydreaming about the exciting things we’ll do like visiting tropical destinations, playing golf, or spending time with our grandkids.
However, it’s essential not to overlook the less exciting aspect of retirement planning: taxes. Without careful planning, federal and state taxes can significantly reduce the size of your retirement savings.
In this article, we’ll explore the various sources of retirement income and how they’re taxed, including information on tax rates and breaks for retirees. We’ll also discuss the impact of estate planning on retirement taxes, before sharing some useful tips to help you minimize the taxes you’ll have to pay during your golden years.
Sources of retirement income
The IRS taxes most forms of retirement income. This includes your Social Security benefits, pensions, and withdrawals from your 401(k)s and traditional IRAs. Some states have different views on retirement taxes, which we discuss in more detail in the next section. But what follows is true for the majority of states when it comes to the main sources of retirement income.
1. Traditional IRA and 401(k)s
Making contributions while you’re working to your traditional IRA or 401(k) can cut your tax bill for that year. But, you will eventually pay tax on that income when you start taking withdrawals. When you take a payout before age 59½, you will be penalized an extra 10 percent. You may be able to delay withdrawing from your plans, but you can’t do that forever. There is a required minimum distribution (RMD) at age 73 for those with traditional IRAs and 401(k)s.
2. Roth IRAs and Roth 401(k)s
With Roth contributions, you don’t get the immediate tax deduction. But, your withdrawals are tax-free. That’s true as long as at least five years have passed since you first contributed and you’re at least at the age of 59½.
3. Stocks, bonds, mutual funds, or dividends
Selling stocks, bonds, or mutual funds that you’ve held for more than a year, you’ll have to pay long-term capital gains rates on the proceeds. The rate of your capital gains tax will depend on your taxable income.
For 2023, filers can have taxable income up to $44,625, $59,750, and $89,250 and not pay capital gains for individual filers, heads of household filers, and joint filers respectively. A 20% rate starts at $492,301 for single filers, $523,051 for heads of households, and $553,851 for joint filers.
What retirement tax you pay on dividends will depend on whether those dividends are qualified (triggers long-term capital gains rates) or non-qualified (taxed at ordinary income rates).
4. Pension payments
Unless you are in a state that doesn’t tax pensions, you’ll pay tax at your ordinary income tax rate. This is true for both private and government pensions.
5. Social security benefits
Whether you’re taxed on social security will depend on what the IRS calls your “provisional income.” In general, the IRS states, “You will pay federal income taxes on your benefits if your combined income (50% of your benefit amount plus any other earned income) exceeds $25,000/year filing individually or $32,000/year filing jointly.” You can determine if your social security benefits are taxable using the IRS’s worksheet.
6. Life insurance & annuities
Any funds you receive as a beneficiary of a life insurance policy when someone dies are typically non-taxable. However, if you trade your policy in for cash, there could be tax implications. The IRS has an online tool for calculating that too.
If you’ve purchased an annuity from a life insurance company to provide retirement income, you will be taxed on the interest earnings. For example, the $120,000 you paid in principal would be tax-free, but the $30,000 your money earned over ten years is taxed as ordinary income.
7. Savings accounts, bonds, and other interest-bearing accounts
You’ll pay ordinary income tax rates on interest from certificates of deposit, savings accounts, money market accounts, and corporate bonds. Municipal bond interest is exempt federally. Interest on bonds from the state where you reside is also typically exempt.
What retirement income is taxed?
You will encounter different rules about retirement income taxes in various states. For example, some states:
- Don’t tax military retirement pay
- Treat pension income differently than distributions from retirement plans such as 401(k)s or IRAs.
- Don’t tax Social Security benefits, there’s “a major trend” among states to cut taxes for retirees, Aidan Davis, director of the Institute on Taxation and Economic Policy, told the New York Times.
States that don’t tax retirement income
If you’re thinking of moving when you retire, you may want to consider the tax implications of your choice.
In many states, retirement distributions are regarded as taxable income. Yet there are eight states that don’t currently tax any retirement income: Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming.
Additionally, these four states don’t tax retirement income:
- Illinois: All retirement income is exempt from paying tax, including pension payments, 401(k) and IRA distributions, and Social Security payments.
- Iowa: Thanks to a law taking effect in 2023, Iowa residents over the age of 55 aren’t taxed on retirement income.
- Mississippi: Retirement income is not taxed as long as you meet plan requirements.
- Pennsylvania: As long as you meet retirement plan requirements, retirement income is not taxed.
New Hampshire also doesn’t tax retirement income. However, it does tax interest and dividend payments, which you’re likely to see from your retirement portfolio.
What will your tax rate be after retirement?
According to research by the Investment Company Institute and the IRS, tax rates fall in retirement for most households. This is because, typically, total income is lower, and only a portion of Social Security benefits are taxable.
As discussed above, whether you have to pay taxes on the benefits depends on your income level and the state where you reside. Every January, you’ll get a form from the IRS totaling your benefits. You can ask that taxes be withheld from your benefits using Form W-4 V.
DYK? Social security benefits were first taxed in 1984. It was part of an effort to stabilize the fund’s finances. The tax revenues go to Social Security and Medicare trust funds.
How tax brackets work and affect your retirement income
Tax brackets don’t change when you’re retired. Your tax rates and tax liabilities will still be determined by your earned and unearned income, the same way they were calculated while you were working.
| Tax Brackets, 2022 | ||||
| 2022 Rate | Married Joint Return | Single Individual | Head of Household | Married Separate Return |
| 10% | $20,550 or less | $10,275 or less | $14,650 or less | $10,275 or less |
| 12% | $20,551 to $83,550 | $10,276 to $41,775 | $14,651 to $55,900 | $10,276 to $41,775 |
| 22% | $83,551 to $178,150 | $41,776 to $89,075 | $55,901 to $89,050 | $41,776 to $89,075 |
| 24% | $178,151 to $340,100 | $89,076 to $170,050 | $89,051 to $170,050 | $89,076 to $170,050 |
| 32% | $340,101 to $431,900 | $170,051 to $215,950 | $170,051 to $215,950 | $170,051 to $219,950 |
| 35% | $431,901 to $647,850 | $215,951 to $539,900 | $215,951 to $539,900 | $215,951 to $323,925 |
| 37% | Over $647,850 | Over $539,900 | Over $539,900 | Over $323,925 |
Tax breaks for retirees
Once you are over the age of 65, whether you have retired or not, the threshold for having to file a return changes. In 2023, the IRS published the following requirements:
- Single, will file if the gross income of at least $14,700
- Married filing jointly, if one spouse is 65 or older, will file if the gross income of at least $27,300
- Married filing jointly, if both spouses are 65 or older, will file if the gross income of at least $28,700
- The head of household will file if a gross income of at least $21,150
- The qualifying surviving spouse will file if the gross income is of at least $27,300
Your filing status has always impacted the standard deduction. Single and married individuals filing separately get the lowest standard deduction. Head of household is in the middle, and married filing jointly filers get the highest standard deduction.
Once you’re over the age of 65, whether you’re retired or not, you’ll be eligible for a higher standard deduction.
| Standard Deductions for Taxpayers Age 65 or Over, Tax Year 2022 | |||
| Filing Status | Standard Deduction | Senior Bonus | Total Deduction |
| Single | $12,950 | $1,750* | $14,700 |
| Married filing jointly or qualified widow(er) | $25,900 | $1,400 per senior spouse | $27,300 or $28,700 |
| Married filing separately | $12,400 | $1,400 | $13,800 |
| Head of household | $18,650 | $1,750* | $20,400 |
Estate planning and retirement taxes
The rules around retirement accounts and estate planning have been changing recently. It’s a good idea to review your will or trust plans to ensure you understand the income tax consequences of your retirement plan assets — for you and your beneficiaries. If this is the first time you have decided to make your retirement plan, read on how to create a retirement plan.
Taxation of retirement accounts after your death is impacted by the age of the decedent and the type of beneficiary. When naming a trust as the beneficiary, the life expectancy of the oldest beneficiary will influence the required minimum distribution payouts. This can make it advantageous to establish a special trust for minors as it can avoid the assets becoming part of a surviving spouse’s estate.
You might leave retirement plan accounts to a charity. This shifts the income tax burden away from your estate and heirs, while charities are not subject to income tax.
Deathbed Roth conversations are another approach to avoid income taxes for the estate or beneficiaries. This allows you to convert from a pre-tax account to an after-tax account so that the taxpayer generates the income tax liability before death.
Tips for retirement taxes
There are strategies you can employ to optimize your tax results in retirement. The following tips may help you reduce the tax consequences you’ll incur.
Diversify
You’ve been hearing that advice throughout your investing years. Well, it continues to be useful in retirement. With the right mix of retirement accounts, you’ll have a greater ability to impact your tax rate in retirement and when and how you make withdrawals in retirement.
When you have multiple sources of retirement income, you can save on your retirement taxes by limiting distributions from your pre-tax plans. Prefer other income sources and only withdraw the amounts you need or are required to withdraw from 401(k) or pension funds.
Convert 401(k) to Roth IRA
You can lower the amount of tax paid on 401(k) withdrawals by converting your traditional 401(k) to a Roth IRA or Roth 401(k). Roth accounts are not taxed as long as they meet the qualified deduction rules.
However, you will pay tax on the money you convert. The more you convert, the more taxes you pay. So, the benefit of this strategy depends on how long you can leave the money in the Roth before making withdrawals.
You might think of this model as paying today for flexibility tomorrow, which can give you increased control of what tax bracket you will fall into in the future.
Make charitable contributions from an IRA
If you are at least 70½, you can donate up to $100,000 annually to charities using Qualified Charitable Distributions. You won’t pay income taxes on these distributions, which count toward your required minimum distributions. Note: If you choose to do this, you can’t also claim the deduction on your Form 1040, Schedule A.
Use a Health Savings Account
If you’re a worker with a high-deductible health insurance plan, you might contribute to a Health Savings Account (HSA) that provides tax efficiencies. Your contributions are tax-deductible as are withdrawals spent on qualified medical expenses.
Those who can afford to pay out of pocket for their current health care expenses could also invest in the HSA balance. That investment growth and interest are tax-exempt.
Start using these strategies for tax efficiency
Whether retirement is near or far on your horizon, you can work to minimize your retirement taxes by understanding the sources of income and how they’re taxed. This article has explored the basics of planning for tax brackets and breaks, estate implications, and tips to manage your retirement income flexibility.